“Kee” Points with Jim Kee, Ph.D.


  • Tax Cuts Look Likely to Pass
  • Quick 2018 Outlook
  • Notes on Sentiment
  • Inflation Not Baked in the Cake


Tax Cuts Look Likely to Pass

Voting is expected this week on the final version of tax reform which, among other things, will lower corporate rates, individual rates, and rates on pass-through businesses. It will also affect non-profits and housing by modifying deductions. Several items could impact municipal bonds, particularly the removal of tax-exempt status that allows municipalities to refinance at lower rates. Lowering corporate tax rates also reduces demand for municipal bonds by corporations, banks, and insurance companies. On Friday, the House and the Senate signed off on a conference report resolving differences in their respective tax bills, and the 503 page report obviously contains the inevitable minutia of negotiations and compromises. Assuming the bill passes this week, I will try to bullet point the main implications for individuals (rates, exemptions, health care), businesses (corporate, pass-through, overseas earnings, etc.), non-profits, and municipalities in next week’s Kee Points.


Quick 2018 Outlook

Most strategists expect positive returns for stocks next year, with the average and median forecasts of ten firms reported by Barron’s (Goldman Sachs, Citigroup, etc.) being in the 6%-7% range. People can’t really predict above or below average markets, of course, because that requires the ability to forecast heretofore unknown events that aren’t already priced-in or incorporated into current prices. But remember that prices lead quantities, and the expectations of higher future growth in the economy and earnings (“quantities”) from tax/regulatory reform should be anticipated somewhat by stocks and bond markets (“prices”). I think that’s what we are seeing, so I think the near-consensus “stronger growth, disappointing returns” (Black Rock) outlook for 2018 is the right expectation.


Notes on Sentiment

So far this holiday season consumer spending in general and retail spending in particular has been well ahead of expectations, which is consistent with extremely high business and consumer confidence readings. Confidence data can be both backward and forward looking, depending upon the circumstances. Under current circumstances, I would say confidence data has anticipated consumer spending, which is consistent with how most people think about consumer sentiment or confidence measures and subsequent spending decisions. But they can also be contrarian indicators in times of macroeconomic shocks. For example, after the 9/11 attacks on the World Trade Center towers, consumer sentiment readings were about the lowest on record. That led to a very dismal outlook for the retail sector by Wall Street analysts. But the following months’ bounce in retail spending were among the strongest on record. Keep this in mind anytime someone tries to read too much into confidence surveys or measures.


For example, the November reading of small business optimism from the National Federation of Independent Business (NFIB) registered the second-highest reading in its 44 year history. There are eight components to the survey-based index, and the strongest gains came in the “Expected Better Business Conditions” component and the “Sales Expectations” component. Other surveys corroborate this, as the University of Michigan Consumer Sentiment Survey recently surpassed its prior 2007 peak for the first time since the expansion began. The NFIB listed expectations of lower taxes as a common component of feedback from survey participants. That suggests that stronger hiring and investment is in anticipation of lower taxes, so the notion that things are improving so a tax cut isn’t needed is a bit disingenuous.


Inflation Not Baked in the Cake

Does growth lead to an “overheating” economy? The notion that growth “causes” inflation is among the most misleading notions in all economics. Towards the end of the high inflation 1970s, economist Robert Mundell, who later won the Nobel Prize, questioned this thinking by asserting that, for a given stock of money, more output would put downward, not upward pressure on prices. That’s because each unit of money would trade for more goods and services, which is disinflationary, not inflationary. Mundell’s prescription, controversial at the time, was to encourage production by reducing taxes and regulatory burdens. Other Nobel Laureates at the time argued the opposite, and were on record asserting that the Reagan tax cuts, if enacted, would lead to high or even hyperinflation by the late 1980s. Mundell was right, output and capital spending rose dramatically during the 1980s as inflation fell, just as real output and capital spending declined in the 1970s, as inflation rose. Part of this success in bringing down the inflation of the 1970s had to do with then Fed Chair Paul Volker’s massively tight monetary policies in the early 1980s (raising short rates dramatically), which induced a deep recession (some count it as two) early on and was believed by Volker and others to be necessary to “break” inflation. Economists advising the administration at the time protested this, arguing that a gradual tightening would have accomplished the same goal with less stress to the economy. We will never know, because the massive tightening was the course that was chosen, not the more modest approach. But the point is that whether or not growth is ultimately inflationary or not depends upon the actions taken by the central bank and the deftness (or lack thereof) of controlling the excess reserves of the banking system.


At the risk of oversimplifying, whether or not strong growth will lead to inflation depends to a large degree on the actions and organization of the monetary system or central bank. Specifically, the ability of the central bank (the Federal Reserve in the US) to manage the excess reserves of the banking system as the economy grows is the key to controlling inflation in an expanding economy. The Fed can control the level of excess reserves held versus loaned out (potentially leading to inflation) by paying interest on reserves as well by buying and selling securities (called “open market operations”) to target interest rates in general. Currently the excess reserves of the banking system are extremely high, a product of the asset purchase programs (i.e. quantitative or credit easing) of the Federal Reserve. That adds a level of complexity to the central bank’s task, a fact pointed out by former US Senator (and PhD economist) Phil Gramm and Texas A&M economist Thomas Savings last week in their Wall Street Journal article, “A Booming Economy Will Challenge the Fed.” The authors expect the US economy to return to its normal 3% growth path (as do I, but we’ll see), and argue that it is quite possible, but not certain, for this to occur with broad price stability:


“If the Fed could find just the right mix of selling more assets and lower the rate it pays on excess reserves, it could theoretically end up reducing its balance sheet and reducing bank reserves without either slowing economic growth or igniting inflation.”


So don’t believe anyone who tells you that high future inflation is already baked in the cake.